What is happening to the bond markets after a Trump victory?

11/19/201603/01/2017 by Editorial Team

The bond markets were in the news for the two straight weeks since the U.S elections held on November 8th 2016. After an initial rally, bond markets fell sharply and continued to fall in the following days making it one of the most talked about asset in the financial media.

It wasn’t just U.S bonds but also across the world, including Japan and Europe. For example, yields on the 10-year government bonds in Japan rose to 0.035% on Friday, November 18th, 2016, up from 0.005% just the day before. It was the first time that yields rose.

In bonds, yields run inversely to prices; meaning that when bond prices fall, yields rise. Learn the basics of bonds here.

Yields on 10-year treasury rise to 2.34%

Blame Trump’s policies for rise in bond yields

After it was clear that Donald Trump will be the next president of the United States, the markets got around to understanding that the president-elect would soon go on a spending spree. As promised in his election campaign, Trump said that he would spend close to a $1 trillion to re-build America and also to bring more jobs to the people.

Of course, this comes at a price that budget deficit will increase sharply.

As far as the bond markets were concerned this week there have been two main stories doing the rounds.

Higher yields are a sign that inflation is rising and thus interest rates will rise

Higher yields are a sign that with promise of more spending, the cost of borrowing will also increase

No matter what the main narrative is, one thing is for sure. The bond markets was in bullish territory for nearly 30 years changed to bearish in a matter of days, which has taken everyone by surprise.

Until the U.S elections, investors preferred to pile up on bonds which were the state of play against easy monetary policies. Indeed, central banks around the world have been in an easing cycle across the major economies, making bonds an attractive proposition. For some brave souls, investing even in the risky corporate bonds seemed like a good idea.

It is estimated that more than $1 trillion in the global bond market valuation was washed away.

Jeffrey Gundlach, a well known bond guru said, “We’ve had a sentiment shift in the bond market. We’ve seen it, too. People have already started reallocating out of bonds and into stocks.”

According to BofA Merrill Lynch, US domiciled funds saw the largest rotation ever seen since June 2013 (taper tantrum) as investors pulled out of bonds and moved into stocks. For the week ending November 16th investors withdrew close to $9.06 billion from bonds with over $25.39 billion inflows moving into sticks, which was the largest on record since December 2014.

Rising yields a sign of inflation expectations

Treasury Inflation protected securities or TIPS for short are securities where the principle is tied into the consumer price index (CPI). The principle rises along with rising inflation and falls with deflation. When the TIPS reach maturity, the U.S. Treasury pays the original or adjusted principle, whichever is greater. TIPS pay interest ever six months and is often viewed as a gauge of investor’s expectations on inflation.

Inflation indexed security: 0.42%, highest since March 2016

Although the 10-year yield is still substantially lower when compared to December last year, the general belief is that yields have more room to rally.

Last week, US consumer price index data showed that inflation rose 0.4% on a monthly basis in October, which pushed the yearly inflation rate to 1.6%.

It was the fastest increase in headline inflation, although core inflation remained moderate. Higher cost of energy, shelter accounted for the increase with gasoline prices alone rising 7% in October. Core inflation rose 0.1% in October but is up 2.1% from a year ago.

The increase in inflation was good news for investors and attributed to further selling in bonds. The Federal Reserve Chair, Janet Yellen in her testimony to congress had this to say:

Were the FOMC to delay increases in the federal funds rate for too long, it could end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of the Committee’s longer-run policy goals,” she said. “Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and ultimately undermine financial stability.

The markets are not pricing in an over 90% probability for the Fed to hike rates, which has added to the intensive selling in bonds.

Higher yields signal higher cost of borrowing

Another narrative that also holds significance is that higher yields will likely see increased cost of borrowing. For example in the early 90’s under the Bill Clinton administration, the then president Clinton contemplated boosting spending. The bond markets quickly adjusted sending yields higher and thus pushing the borrowing costs higher as well. This eventually led to Clinton doing an about turn and focused on reducing the budget deficit.

The falling bond prices suggests that bond traders are betting that Trump will have to borrow more from the market by issuing more debt. Just over a month ago, the U.S. Committee for a Responsible Federal Budget in a fiscal fact check paper estimated that if Trump goes through with his campaign promises of increased spending, it would add an additional $5.3 trillion to the U.S. national debt or close to 127% in debt as a share of GDP by 2026.

With increased spending, lower taxes, not only is the budget deficit expected to widen but alongside a crackdown on immigration and cheap imports from China, inflation is expected to rise as a result.

Despite making the strong headlines this week, the bond markets were in fact shifting ever since the Fed lifted interest rates last December, but some analysts urge caution. “If this is indeed the beginning of the massive rotation, it will take a long time to play out. We would need to see weeks and weeks of bond outflow. At this point, it’s too early to conclude anything,” Mike Antonelli, equity sales trader at Robert W. Baird & Co. told Marketwatch.

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